Investors have dismissed fund-of-hedge-fund products (FoHFs) as a result of the global deleveraging event in 2008. While this event caused concern for many investors, the catalyst for this was a structural issue: a combination of a run on client redemptions; gross leverage of 175 per cent going into the global financial crisis (GFC); and prime brokers tightening their collateral requirements.
A further structural issue facing the hedge fund industry was that some funds initiated “gate” and “catch-all” provisions – that is, the ability to limit or halt withdrawals respectively. This was typically done by those funds that either couldn’t price assets in their strategy or whose redemptions were of a magnitude that meant an orderly exit from the market couldn’t be achieved without disadvantaging remaining investors. This meant that funds not facing these issues and remaining open to redemptions then became the “victims” and were found to be a means by which investors could secure liquidity in the asset class.
Given this structural backdrop, I believe the investment merits of FoHFs are still valid after the crisis. In fact, the statistics suggest that an investment in FoHFs can play an important role in achieving overall portfolio diversification and help mitigate downside risk.
As the tennis great of the 1970s, Arthur Ashe, once remarked: “Either you understand your risk or you don’t play the game.”
| What is a hedge fund? A portfolio of investments, the investment manager of which is free to operate in a variety of markets and can employ strategies that allow him to pursue absolute returns, rather than being constrained to market benchmarks. The investment strategy seeks to reduce exposure and correlation to traditional markets, while exploiting inefficiencies in those markets. |
Basic assumptions
Many commentators see hedge funds as an evil force in the markets. Indeed, governments and regulators are known to ban short selling in times of market stress, in complete opposition to most academic research. This is not a recent development. During the French Revolution, such speculators were known as agitateurs and were beheaded. Thankfully guillotines are relics of a past age.
The term hedge fund is a misnomer as no investment product hedges away all risks. Indeed, taking the argument to its fullest extent suggests that such funds would never make a return. In other words, returns are a function of taking risk. However, hedge funds differ from their traditional brethren by attempting to reduce their exposure to unwanted risks and seeking returns from risks that have more predictable outcomes.
All active asset managers seek “alpha”. For traditional investment managers this often means outperforming a benchmark, where success is losing only 38 per cent when the market is down 40 per cent. However, for hedge funds there are no market benchmarks – just an absolute return target.
In terms of risk control, the traditional manager will make active bets that are larger or smaller than the reference index, resulting in tracking error. The hedge fund manager seeks to control additional risks in order to produce positive returns. The difference in risk management requirements of the two processes is enormous. In fact there are many commentators who would suggest that traditional managers are passive in respect to total risk management.
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| Tracking a risky business Zenith Investment Partners’ Approved FoHF Index compares favourably over the past 10 years with the Australian All Ordinaries Index, the HFN Fund of Fund Multi Strategy Index and the MSCI World Index A$. The Zenith Approved FoHF Index, and to a lesser extent the HFN Fund of Fund Multi Strategy Index, demonstrate clearly the positive effects of managing downside risk, and by association, the implications for long-term wealth creation. Assuming the equity indices recover at 8 per cent per year – without any further downside surprises – the Australian market will be back at its peak toward the tail end of 2018, representing more than 10 years of catching up.The global equity market, based on the same assumptions, will recover some time in 2017.While equity markets will catch up, the Zenith Approved FoHF Index, assuming 7 per cent per annum steady returns, will be 50 per cent above its previous high-water mark. The purpose of this argument is not to debate the long-term performance of equities. Rather, the analysis suggests some investors may not have the investment timeframe to be able to sustain the large risk exposures associated with equity markets.The following table highlights the volatility and absolute and risk-adjusted performance of each category. The statistical analysis from the return profiles of the Zenith Approved FoHF Index and the HFN Fund of Fund Multi Strategy Index suggests that FoHF products exhibit volatility of roughly between one-half and one-third of equity indices (as measured by standard deviation), deliver a stronger risk-adjusted performance result (as measured by the Sharpe ratio) and have delivered stronger historical compound and cumulative absolute returns.
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How the hedge grew
Hedge fund pioneers set up vehicles that were private in nature, with the principals having significant personal stakes in the management company and in the fund. However, in 1999 the scene changed with the California Public Employees’ Retirement System (CalPERS) allocating resources to hedge fund managers. Institutions in Australia followed suit, with investment by a number of superannuation funds in 2001. These events legitimised hedge funds, with growth in hedge fund investments in Australia rising from $A2 billion in 2001 to more than $A90 billion in 2007.
Initially, hedge funds were run by successful investors, often from investment banks. These investors looked to run their funds in the way they had learned at proprietary trading desks. Earning a return on funds was their motivation. Many of the structures assembled for such managers were self-serving – that is, they were designed to look after the principals’ interests first.
The expectation in the industry and among many seasoned investors was that with increased institutional participation in hedge funds would be lift their quality. On many measures this is true. However, investors not only sought absolute returns, they began to seek continuous substantial returns. In doing so, they forgot that the size of returns has a relationship with risk.
Before the GFC, there was also increased demand from investors to find hedge funds in what is a skill-based asset class. This led to greater differentiation between quality and sub-standard managers and, as a result, growth in the form of FoHF products given as many investors wanted to outsource manager selection without incurring the cost of undertaking this search.
The events of the past few years have shown in sharp relief the clash of the traditional, market-influenced approach with the alternative, non-benchmark philosophy. The traditional approach values time in the market and ignores short-term volatility, while alternative-approach hedge funds on the whole seek to reduce volatility, suggesting that they look in the long run to avoid large losses, giving investors an increased chance of positive compounding.
Returns, transparency, liquidity and cost
While we have found that the FoHFs – and their cousins, multi-strategy funds – do add value to investors, we acknowledge that the asset class introduces some issues. Those regularly mentioned include dispersion of returns, transparency, liquidity and cost.
Due to the very nature of hedge funds (a skill-based rather than market-based attempt to capture market inefficiencies), dispersion of returns is expected. To an investor with no edge this is a risk, but to an active investor, such as a FoHF with a competitive advantage, this is an opportunity to add value.
Investors are also demanding greater transparency. While the industry has made progress toward this since the GFC (that is, the rise in prominence of managed accounts), there are still some aspects of hedge funds that remain opaque and transparency remains lower than in traditional asset classes. Although I believe further improvement in transparency come about over the coming years, its value may be moot. While the average investor might have some brand recognition with listed equity companies (Woolworths, BHP et cetera), the same cannot be said for a list of hedge funds, and knowledge in this sector is only attainable at a high cost.
While most investors find comfort in the fact that most hedge fund managers have a significant portion of their own personal net wealth invested in their funds (the same cannot typically be said of traditional fund managers), the longer redemption terms of hedge funds are often frowned upon. A more pragmatic view is that hedge funds exploit inefficiencies and, as such, these positions cannot be as quickly unwound; and there is a liquidity cost in accessing these uncorrelated returns.
While in Australia the trend has been towards meeting the need of the investor and creating daily liquid FoHF products that are suitable for platforms and typically incorporate beta replication strategies, the jury remains out on the long-run success of this model. Furthermore, I suggest that engineering a product to achieve a liquidity outcome is fraught with danger (à la the hybrid property funds launched in the 2000s for the platform market) and in doing so, sometimes these strategies can inadvertently “cull” some of the best hedge funds, which either aren’t prepared to alter their liquidity terms and/or whose underlying strategy does not allow it.
“Either you understand your risk or you don’t play the game” – Arthur Ashe
Finally, the cost argument is often twofold for FoHFs. Firstly, the underlying managers charge higher fees than traditional funds and secondly, a double layer of fees typically exists with this type of product. While I do not disagree with this, I think investors are aware that there is a distinction between alpha and beta and that it’s reasonable to expect that active fees should be paid on active management and passive fees on passive management. Furthermore, excess returns are attributed to skill, which is scarce and costly, while market exposure is not.
A 1997 study by Fung and Hsieh looking at US mutual/managed funds versus hedge funds found that more than half the mutual/managed funds had R2 above 75 per cent, while nearly half of hedge funds had an R2 of below 25 per cent. Under this type of style regression analysis, an R2 reading of 100 per cent indicates 100 per cent of the return is attributable to asset classes (that is, market indices) whereas a reading of 0 per cent indicates the performance is not attributable to any asset classes.
Regardless of how much credence you place in the findings of the this study, I believe that any fee argument needs to be considered in the context of the value added on an after-fee basis (like all of the above analysis), because this is what the investor receives and this is what should matter.
David Smythe is director and joint founder of Zenith Investment Partners, a research business.
